Policy Brief NUMBER PB16-4 APRIL 2016 Quantitative Easing: An HOW DOES QE WORK? Conventional monetary policy works by reducing the short- term interest rate, which encourages consumption and invest- Underappreciated Success ment. QE works by reducing the long-term interest rate, which also encourages consumption and investment.1 Central banks Joseph E. Gagnon are still assessing whether and how to make QE a standard part of their policy toolkit, but policymakers have little doubt that Joseph E. Gagnon is senior fellow at the Peterson Institute for QE does operate in many ways like conventional monetary International Economics. He served at the US Federal Reserve as visiting policy. associate director, Division of Monetary Affairs (2008–09); associate director, Division of International Finance (1999–2008); and senior In advanced economies during and after the Great Recession, economist (1987–1990 and 1991–97). He also served at the US Treasury QE operated through three channels: (1) reducing risk spreads Department (1994–95 and 1997–1999) and taught at the Haas School associated with market panics, (2) reducing expectations of the of Business, University of California, Berkeley (1990–91). He is author future short-term policy interest rate, and (3) reducing the term of Flexible Exchange Rates for a Stable World Economy (2011) and The Global Outlook for Government Debt over the Next 25 years: Implications for the Economy and Public Policy (2011). Quantitative easing can be especially © Peterson Institute for International Economics. All rights reserved. powerful during times of financial stress, but it has a significant effect in normal After short-term interest rates in many advanced economies fell below 1 percent, central banks turned to quantitative easing times with no observed diminishing returns. (QE) to support economic growth. They purchased massive and unprecedented amounts of long-term bonds in an effort to premium in bond yields by reducing the supply of long-term reduce long-term borrowing costs. Nevertheless, recovery from bonds in the market.2 At this stage, with reasonably well-func- the Great Recession proved disappointingly slow. Recently, tioning markets and market expectations of future policy rates in some central banks have pushed short-term interest rates line with—or even lower than—rates suggested by central bank slightly below zero to provide an additional boost to growth. announcements, only the third channel remains potent, giving The slow recovery and the turn to negative rates have raised rise to the perception that QE has a diminishing effect. But the questions about the benefits of QE bond purchases and whether their effectiveness has reached a limit. Meanwhile, there has been an explosion of research on QE 1. QE also can operate through direct or subsidized lending and purchases of other assets such as equities and real estate. Such programs are less common and its effects. By and large, this research has attracted little and less studied. The Bank of England and the European Central Bank operate attention from the public or even the financial press. Studies subsidized lending programs. The Bank of Japan purchases equity and real overwhelmingly agree that QE does ease financial conditions estate investment trusts. Gagnon and Hinterschweiger (2013) present a com- prehensive review of the crisis responses of the central banks of the four main and there is no reason to doubt that it supports economic advanced economies as of December 2012 as well as a survey of studies on the growth. QE can be especially powerful during times of finan- effects of the various programs. cial stress, but it has a significant effect in normal times with 2. The yield on a long-term bond is commonly divided into two components: no observed diminishing returns. Rarely, if ever, have econo- the average expected value of future short-term interest rates over the life of mists studying a specific question reached such a widely held the bond and the term premium. Neither component can be directly observed, but there are techniques for estimating the expected value of future short rates, consensus so quickly. But this consensus has yet to spread more including through surveys of bond market participants. The term premium broadly within the economics profession or the wider world. equals the bond yield minus the average expected future short rates. 1750 Massachusetts Avenue, NW Washington, DC 20036 Tel: (202) 328-9000 Fax: (202) 328-5432 www.piie.com NUMBER PB16-4 APRIL 2016 evidence suggests that there is no tendency for the third channel, the results are not particularly sensitive to the size of the event known as the portfolio balance effect, to diminish.3 Indeed, window. there are grounds to believe that the portfolio balance effect may When QE programs catch markets by surprise, simply be increasing, as additional QE bond purchases remove bonds adding up the yield movements in the windows is a reasonable from investors who are more reluctant to sell them and thus who way to estimate the total effects of QE on yields, as long as the demand ever higher prices (and lower yields). No central bank study includes all events in which news about the QE program has pursued QE to an extent that would allow for a test of the was released. Arguably, these conditions existed around the “increasing potency” hypothesis. time of the first QE programs in the United Kingdom and the United States in 2008–09. For later QE programs, this approach Central banks are still assessing whether does not work well because markets began to anticipate the possibility of additional QE based on economic data before and how to make QE a standard part of central banks announced it. For later event studies, researchers their policy toolkit, but policymakers have typically try to include other news events besides central bank announcements, such as data releases, that might have conveyed little doubt that QE does operate in many information about future QE or they use survey information on market expectations about future QE purchases before any ways like conventional monetary policy. central bank announcement.4 Churm, Joyce, Kapetanios, and Theodoridis (2015) use daily deviations between UK bond However, as with short-term interest rates, there remains yields and foreign bond yields to estimate changes in market the issue of a lower bound on long-term interest rates. Ten-year expectations about UK QE. government bond yields are slightly below zero in Japan and The simplest event studies report the entire effect of QE Switzerland. Additional QE purchases of 10-year bonds in announcements on bond yields. Some studies delve further and these countries might not drive yields much further below zero attempt to parse out the channels, focusing mainly on guid- because investors have the option of holding paper currency ance about future short-term rates and the term premium.5 A with a fixed yield of zero. considerable element of judgment enters into these estimates, which rely on comovements of Treasury bonds at different maturities. As shown in table 1, the two studies by Christensen STUDIES OF QE EFFECTS ON BOND YIELDS and Rudebusch find relatively small effects of QE on the term Since 2010, an outpouring of research has focused on the finan- premium. But it is important to note that their studies do not cial market effects of QE (table 1). To date, the vast majority imply small overall effects of QE. Rather, they find that QE of QE purchases have been limited to government bonds, or reduces expectations of future short-term interest rates much government-guaranteed bonds in the United States. Table 1 more, and at longer horizons, than most other studies find. displays estimated effects on the 10-year government bond yield The other broad category of studies is time series regressions of a QE bond purchase equivalent to 10 percent of GDP. These of bond yields or term premiums on the supply of long-term studies unanimously conclude that QE lowers bond yields bonds. Most of these studies use samples that end before the significantly, even when focus is limited to the portfolio balance launch of QE programs, in part because they were done near effect and not the other channels. the beginning of QE and in part because of the concern that As shown in table 1, the two most common types of QE QE announcements would change the timing of the response of 6 studies are event studies and time series studies. The simplest yields to bond supply. Because these studies generally focused event studies add up movements in bond yields around central on normal market conditions and central banks were not using bank announcements concerning QE programs. Studies use QE to guide expectations of future short-term interest rates, different sizes of event “windows,” from 30 minutes to 3 days bracketing the announcements. Shorter windows risk missing some of the market reaction; longer windows risk including 4. A later event study that does not control for market anticipation of QE is the effects of other news that is unrelated to QE. By and large, that of Fukunaga, Kato, and Koeda (2015), which may partially explain the low estimated effect. 5. These studies focus on the most liquid (on the run) Treasury bonds in order 3. Some observers have argued that QE cannot push the term premium below to minimize any influence from market-calming effects. zero. However, the term premium has been significantly below zero at times, 6. The concern is that QE announcements would bring forward the normal and there is no theoretical lower bound. For some classes of investors (life response of yields to supply as markets come to anticipate supply shifts. An insurance companies, pension funds) long-term bonds may be less risky than exception is the study of Fukunaga, Kato, and Koeda (2015), which includes short-term bonds and thus can have a lower expected rate of return.